WARNING: A Centralized Derivatives Clearing House Will Create Invisible and Deadly Global Risk

The idea of forcing over-the-counter derivatives trading out into the open has widespread support in financial and regulatory circles. Unfortunately, the most popular mechanism for doings so would create giant systemic risks that would likely require a government bailout in the future.

It may not be a bad idea to trade derivatives on exchanges. More transparent pricing would be welcome by many market participants. (Although, we suspect that ambitious traders will simply find markets with less efficient pricing and wider spreads.)

But the idea of creating a central clearing house that would eliminate or reduce counter-party risk in derivatives trades is awful. Rather than actually reducing risk, the risk would simply be shifted to the clearing house. Worse, instead of having a diversity of market participants individually responsible for monitoring their own counter-party exposure, we would be stuck with a centralized, monopolistic monitoring that would likely increase risk.

The clearing house would almost certainly be viewed as too big to fail by market participants, which would mean that its own customers, creditors and managers would not closely monitor its risk. It would be able to avail itself of cheap funding due to its implicit government backing, which would scramble any attempt to manage risk responsibly.

Close government supervision would be unlikely to ameliorate this risk. Fannie Mae, the closest analogy to a derivative clearing house, was one of the most regulated financial institutions ever created. But it was able to control its regulators and expand its balance sheet to the point of collapse.

But if the plan is so risky, why is it getting such wide support from banks and Wall Street? The reason is simple: by taking the risks away from market participants and shifting them onto a clearing house, the plan would force the public to subsidize the risk taking in the derivatives market. It is, in short, another path to socialized losses and privatized profits. Of course it has support from the firms that would be subsidized.

In today’s Financial Times, Asia-Pacific chief executives of futures broker Newedge sounds the alarm on the risk of a centralized clearing house.

“The risk we see is that…it would transfer the risk from bank to bank, to a clearing house, which, being private, would also have to make a profit and we could create a globally risky situation,” he tells the FT.